Why a 5/1 ARM Might Work for You

A quick glance at the BankingMyWay.com mortgage survey tells a familiar story: the 30-year fixed-rate loan is a great deal, averaging just a tad more than 5%. But what about adjustable-rate mortgages, which have been in the doghouse for several years? Are none worth a look?

Actually, the 5/1 ARM has a lot going for it, especially for borrowers with short time horizons or a stomach for risk.

A 5/1 ARM carries a fixed rate for five years then switch to a floating rate that generally is reset every 12 months for the remaining 25 years. It's a hybrid between a fixed-rate loan and a one-year ARM, which has its first adjustment after only 12 months. Today’s one-year ARMs, charging about 3.8%, don’t offer enough upfront savings to counter the risk of higher payments so soon.

Currently, the average five-year ARM charges 4.1% for the first five years, nearly a percentage point below the 30-year fixed rate and just a tad higher than the one-year ARM.

The ARM vs. Fixed-Rate Mortgage Calculator shows that the first five years of payments on a $300,000 loan would be $1,450 on the ARM, $1,610 on the fixed loan. The ARM would save you $160 per month, or $9,600 over five years.

After that, there’s no telling what would happen. Many ARMs allow rates to change as much as two percentage points per adjustment, with a six-point lifetime cap on increases. If the rate went up to the maximum 6.1% after five years, payments would jump to $1,768.

If the rate stayed at 6.1% for years six through 10, the higher payment would wipe out all that you’d saved in the first five years by choosing the ARM over the fixed loan. On the bright side, that means you’d have been no worse off for using the ARM.

Also, the lower rates on the ARM cause you to pay down the debt faster. After five years, you’d still owe $275,486 on the fixed-rate loan, but $271,778 on the ARM. So that’s another $3,700 gained.

Of course, the ARM could go to 8.1% after year six, and even higher later. In that case you really would lose money. Don’t get an ARM unless you can handle the highest payment possible.

Generally, ARMs are most suitable for people who correctly bet that interest rates will stay low or fall. If rates rise significantly, you’d do better locked into a low rate with a fixed loan.

But a five-year ARM is also useful for the borrower who will not need the loan for very long. These days, that could include someone who wants to buy a retirement home while prices are low and can hold off selling their current home until prices go up.

If that bet worked, the borrower would use the proceeds from the older home to pay off the mortgage on the newer one, gaining the benefits of the low rate for up to five years while avoiding the risk of higher rates later.

An ARM can also pay if you can put the monthly savings to a better use, such as a long-term investment or a college savings plan.

Use the search tool to dig up market-beating deals. Wells Fargo (Stock Quote: WFC) and Bank of America (Stock Quote: BAC), for instance, offer five-year ARMs at just 3.75%.